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Due Diligence in Buying Commercial Real Estate:
Acreage, Apartments or a Building

Due diligence prior to a real estate closing helps buyers and investors assess risk and achieve their expectations for the property.

Related Article: Due Diligence Periods and the Enforceability of Purchase Contracts

 

Janet Jackim  

Wikipedia defines “due diligence” as “reasonable steps taken by a person in order to satisfy a legal requirement, especially in buying or selling something.” Due diligence is generally considered to be the series of steps a buyer takes prior to closing on the purchase, to identify all facts and characteristics of the property so that the buyer can make an informed decision on whether to buy.

Whether you are a real estate broker working for a client or you are an investor, the goal is to realize a good investment in the property. Due diligence prior to closing helps the parties assess the risk of the investment and achieve their expectations for the property.

Practice Tip: You want to purchase a fully leased retail building with five store leases in effect. You’ve opened escrow and are waiting for a title commitment. Your broker sends you a copy of the leases, and, during review of the leases, you learn that two of the leases expire in two years or less and one of the leases expires in six months. Based on these terms, three of the five stores will require new tenants soon. In a growing economy, you might like this flexibility to permit you to increase rents in the near future, but in a failing economy the financials of this building will change negatively very soon. Here, due diligence on the leases is invaluable.

Who performs due diligence?

Typically, due diligence activities are conducted by a team composed of the buyer and the buyer’s professionals, including an accountant or tax advisor, attorneys, an escrow company and, depending on the type of transaction, an architect, engineer/surveyor, appraiser, environmental consultant and property manager.

Practice Tip: If you are actively buying properties or expect to buy, compile your team of professionals in advance of a purchase. Assign the role of project manager to someone on your team and task him/her to keep track of pending and completed due diligence activities, due dates (e.g., the end of the due diligence period, closing date, etc.), the person assigned each activity, and analysis and conclusions reached by the team on each activity. The team should meet periodically to keep on top of the results of their due diligence efforts.

When is due diligence performed?

Some due diligence should be performed even before a letter of intent or purchase and sale agreement is inked. The results of this early, important due diligence may suggest that you not spend any more time or effort going forward with the transaction or that you offer a reduced purchase price reflecting the results of your due diligence on the property.

Practice Tip: Efficient and inexpensive due diligence can be conducted on the seller and the property prior to contracting to buy. Substantial information exists online, including these resources associated with Phoenix-area properties:

Maricopa County Recorder’s Office

  • Properties in the County owned by the seller

  • Liens and loans on title to the seller’s property

  • Conditions, covenants and use restrictions

  • History of ownership of the property

Maricopa County Assessor’s Office

  • Current ownership of the property

  • Type of property

Arizona Corporation Commission

  • Owner or management of an entity

  • Whether an entity is authorized to conduct business in Arizona

Clerk of the Superior Court of Maricopa County

  • Pending and concluded litigation against a seller

Practice Tip: Substantial due diligence should be conducted during the “free look,” “investigation” or “due diligence” period described in the purchase and sale agreement. Typically, this period lasts from 10 to 90 days, but can vary with the transaction. Also, the purchase and sale agreement will usually require that all due diligence occur before the end of this period, and due diligence not timely performed is typically deemed waived. During the due diligence period, but not afterward, the buyer will generally be permitted to terminate the transaction.

Which due diligence activities are common?

Common due diligence activities involve investigating the history of the property, the condition of title, property boundaries and physical characteristics, and contracts, including leases if applicable.

Practice Tip: Checklists of due diligence activities keep the buyer and real estate agent organized and on top of various due dates and the persons responsible for performing the activities. Findings can be exchanged among the due diligence team members.

DUE DILIGENCE ACTIVITY

Review of Historical Documents Concerning the Property

  • The title commitment and/or title policy issued on the seller’s purchase of the property may disclose former leases and liens.

  • Local government zoning and building files may disclose variances and special use permits that indicate building or use violations and proposed nearby development or redevelopment plans.

  • Local government records of historic permits, licenses and contracts may disclose the presence of hazardous substances and prior uses.

  • A zoning verification letter to confirm current zoning and uses, special use permits and variances can be obtained from local government agencies.

  • Review of online government records can reveal the status of real estate and franchise tax liabilities, operating licenses and construction permits.

  • Seller’s policies and procedures manuals can reveal compliance or non-compliance with various laws on employment, taxation, use and other business conduct.

Review of Buyer’s Title Commitment and Schedule B Exceptions Described in the Commitment

  • Discloses ownership of the property.

  • Discloses other persons/entities claiming an interest in the property (tenants, easement owners, contractors and lenders).

  • May disclose past or current uses of the property or use restrictions.

  • Discloses recorded development agreements between an earlier developer and the local governments.

  • Discloses litigation involving the property.

Review of an ALTA Survey of the Property

  • When compared against the title commitment, the survey can reveal unrecorded easements, boundary encroachments and adverse possessions.

  • The survey should be “certified” to the buyer, seller (if seller pays for the survey or is the carryback lender), title insurer and buyer’s lender. The certification of the registered surveyor is essentially a warranty of the survey’s accuracy.

Onsite Property Inspection

  • Discloses the condition of the roof, windows, flooring and mechanical infrastructure.

  • Allows the development of a list of furniture, fixtures and equipment in or on the property and the ownership thereof.

  • Allows a comparison between the actual condition of the property versus the construction plans, engineering and architectural drawings, licenses and permits to identify variations and violations.

  • Determines whether the property has been maintained and inspected periodically.

Review of Contracts, Warranties and Licenses Concerning the Property

  • Maintenance agreements may document the need for and extent of future capital expenditure requirements.

  • Ongoing contracts, such as a property management agreement, landscaping agreement or HVAC maintenance agreement, may be unacceptable to the buyer, and buyer may want them to be terminated at closing.

  • Tenant estoppel agreements obtained prior to closing document whether, and to what extent, a tenant has claims against the landlord/seller for breaches of landlord’s obligations under the lease.

  • Warranties on construction of the buildings and equipment may be in effect and can be assigned to the buyer.

Review and Summary of Leases

  • A summary of lease terms is useful to determining the value of the property.

  • A review of the leases will reveal tenant rights to lease extensions, purchase of the property or early terminations of the lease.

  • A review of the leases will reveal the leases’ term length and amounts of current and future rentals.

  • Tenant estoppel certificates can confirm that no landlord or tenant defaults exist.

  • A review of the leases can reveal landlord commitments to maintenance, signage, exclusive parking and exclusive use restrictions.

Conclusion

The importance of conducting organized, concerted efforts to determine all there is to know about a potential investment in commercial real estate cannot be understated. A wise buyer intending to invest in commercial real estate conducts an investigation into historic records concerning the property maintained by the seller and local governments, the condition of the property’s title, a physical examination of the property, its physical characteristics and infrastructure, and various contracts – such as leases – that affect the property. These due diligence activities maximize the investment decision and minimize post-acquisition risk.

 

Janet Jackim represents buyers, sellers, borrowers, lenders, developers, landlords and tenants of commercial real estate in Arizona. Janet has been practicing law, with an emphasis on commercial real estate and business, since 1978, and she has completed thousands of commercial real estate transactions. Janet can be contacted at 480-425-2616 (office) or 480-513-9288 (cell) or email.